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The New Zealand Superannuation Fund appears to have made a rare
misstep with its investment in Portugal’s Banco
Espirito Santo, which led to a $150 million write-down and left
the fund embroiled in two separate court cases. But are angry
stakeholders treating the fund too harshly?

It was supposed to be a low-risk investment. On July 3, 2014,
the New Zealand Superannuation Fund teamed up with New
York-based Goldman Sachs Group and a number of asset management
firms to provide a $784 million loan to Lisbon-based Banco
Espirito Santo (BES), then Portugal’s largest
listed bank, in a complex arrangement involving a vehicle named
Oak Finance Luxembourg. Shortly thereafter, things began to go
wrong.

The first signs of trouble came on July 24, when BES Chairman
and CEO Ricardo Espirito Santo Silva Salgado was detained for
questioning on suspicion of fraud, money-laundering, document
falsification and embezzlement. When a new management team took
over, it discovered big losses at BES that had previously gone
unreported. In early August, Banco de Portugal, the central
bank, was forced to step in with €4.9 billion ($6.6
billion) of support, setting up a new state-supported bank
called Novo Banco to collect most of the stricken
lender’s assets.

Nine months later, and NZ Super is still dealing with the
consequences of its investment in the collapsed bank: Two court
cases, a torrent of negative media coverage — and
losses of some $150 million.

New Territory for NZ Super

All this represents unfamiliar territory for the $21.5 billion
fund, which has earned a reputation as one of the
world’s savviest institutional investors since CEO
Adrian Orr took the helm in 2007. NZ Super has returned over 10
percent annualized since inception, in part by "tilting" its
portfolio toward profitable assets. It also formed innovative
co-investment partnerships to identify new private market
opportunities. So how to account for the failure of NZ
Super’s investment in BES? Or, as the New Zealand
Herald bluntly put it: "What were they thinking?"

The fund has strived to answer that question. "In making this
loan, the Fund was providing liquidity to the Portuguese
banking system," said Orr in a statement in February 19, as the
details of the case first began to draw the attention of the
media. "The Fund was protected against the risk of Banco
Espirito Santo defaulting through the purchase of credit
insurance. This is a very standard, insured, investment
activity globally that keeps the financial world liquid."

NZ Super states that it could not have known about the
bank’s financial troubles, which were disguised by
Salgado’s alleged manipulation of the books. A
report by a Portuguese parliamentary commission said on April
17 that Salgado was "probably involved in a decision to
manipulate the accounts" of Espirito Santo Financial, the
holding company for BES.

In any case, NZ Super says it took the necessary precautions on
the investment. The fund bought bonds issued by Oak Finance,
which in turn used the capital it raised to provide BES with
the $784 million loan. NZ Super purchased credit protection on
BES and believed that the structure of the deal made it an
owner of senior-secured debt in the bank, which would provide
some protection if it went under.

It didn’t quite work out that way. After
transferring the Oak Finance loan to Novo Banco along with
other senior-secured debt, Banco de Portugal moved the loan
back to the by-now insolvent lender — the "bad" bank
— in December 2014. This not only wiped out the
loan’s value, but rendered NZ Super’s
credit protection worthless, because the bank was deemed to
have undergone a "succession event," in the
insurer’s parlance. The fund has consequently
taken the precaution of writing down the loan on its balance
sheet, although it is hopeful of recovering its losses.

Last week, NZ Super began legal proceedings against the
Portuguese central bank challenging its decision to transfer
the loan out of Novo Banco. It is also pursuing debt recovery
proceedings against BES in the U.K. alongside the other Oak
Finance investors, which include an investment vehicle owned by
Indian steel magnate Lakshmi Mittal. One key investor ally: New
York-based Elliott Management Corp., an activist hedge fund
that often invests in distressed sovereign debt and is known
for its tenacity in court as well as its superior returns over
time.

"The Bank of Portugal acted retrospectively and arbitrarily in
treating Oak Finance’s loan to BES unequally to
other senior debt holders, causing the fund’s
credit protection to be ineffective," a spokesperson for NZ
Super told Sovereign Wealth Center via email. "We believe [the
Bank’s] actions are wrong and are based on a
misunderstanding of the facts regarding Goldman
Sachs’ holding in BES and its relationship with
Oak Finance."

The crux of the issue is an item that was written into
Portuguese law on August 1, 2014, just days after the losses at
BES were uncovered. The amendment introduced a new rule to
Portugal’s insolvency procedures: Shareholders
with more than 2 percent of an insolvent bank would not be
eligible for support in the event of a state-led restructuring.
The rule, which Banco de Portugal enacted with retroactive
effect, was intended to ensure that those responsible for a
bank’s distress bear the brunt of its
losses.

Banco de Portugal transferred the Oak Finance loan back to the
bad bank because it determined that Goldman Sachs owned more
than 2 percent of BES at the time the loan was made. NZ Super
contests this ruling on two counts. First, Oak Finance was an
independent entity, so Goldman’s shareholding was
irrelevant. Second, Goldman did not own more than 2 percent of
BES unless, as Banco de Portugal does, one includes some
non-voting shares the investment bank borrowed for a week in
late July using swaps.

"As Goldman Sachs has said publicly and to the Bank of
Portugal, Oak Finance was an independent entity from Goldman
Sachs International," Orr said on February 19. "We understand
that at no point did Goldman Sachs hold a participatory
interest in more than 2 percent of Banco Espírito
Santo’s shares."

Due Diligence

The question remains, however, as to whether NZ Super did
sufficient due diligence on the bank before its investment. The
fund cites BES’ quarterly financial statements
from May 2014, which showed its Tier 1 capital ratio —
the amount of liquid capital a bank holds as a bulwark against
unexpected losses as a percentage of its overall risk-weighted
assets — stood at 9.8 percent, well above the minimum
level required by regulators. It also points to a statement
from Banco de Portugal from July 2, the day before the
investment, which affirmed BES’ "strong solvency
position."

But that reasoning hasn’t stopped some New Zealand
media outlets from criticizing the fund for its perceived
pursuit of "exotic" investments that put
taxpayers’ money at risk. "The BES debacle has
left [NZ Super] with egg on its face," wrote Christopher Adams
in the New Zealand Herald, the country’s most-read
newspaper. "Surely a bit of digging would have revealed the
sickly state BES was in by July last year."

This domestic controversy speaks to the difficulties sovereign
wealth funds can have in justifying their investment decisions
to their ultimate stakeholders. NZ Super argues that what it
calls the "Oak Finance matter" should be viewed in the context
of its overall impressive performance. "Even after the
precautionary write-down of the Oak Finance loan, [the active
investment strategy] has added NZ$900 million in value to the
fund since inception," according to the fund
spokesperson.

Orr himself penned a response to the Herald that pointed out
"the problem has arisen solely because of the arbitrary and
retrospective actions of the Bank of Portugal, subsequent to
our investment, in treating our loan unequally to other senior
debt holders and causing our insurance to be
ineffective."

If there’s a note of exasperation there,
that’s perhaps not surprising, given the tiny dent
the Oak Finance fiasco has made in the fund’s
overall performance figures. Buried at the very end of the New
Zealand Herald’s strident editorial was a line
that hinted at this wider story: "The fund's expected annual
return rate has been calculated to drop from 10.01 per cent to
9.98 per cent." A loss of $150 million is no tempest in a
teapot. But in the context, it’s some way short of
a catastrophe.

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